Financial Accounting

Question 1

When to recognize revenue

Answer 1

When customer starts to derive “economic benefits”

Except in long term contracts, where you use %completion

Question 2

Other times to recognize revenue

Answer 2

Cash received (what if product doesn't arrive)
Sale agreed (what if sale cancelled)
Customer received product (what if it's returned)

This, “economic benefits” under IFRS is best

Question 3

Recording revenues on IS or BS

Answer 3

IS: Accurate performance (relevant)
BS: Defer revenue (matching and reliable)

Question 4

Realization

Answer 4

Realization is the TIMING of recognition

Recognition is continuous: sales flow in, but products may be returned.
Realization ends this process: it is the final accurate and exact totals

Recognition can be manipulated through deferrals. Realization cannot

Question 5

Relevance vs reliability

Answer 5

Trade off: early information is VERY relevant, but will be uncertain and less reliable

IFRS is FVA, meaning that it favors relevance
HCA would favor reliability

Relevance is most important in dynamic changing environments
Reliability is most important when FRs not accurate, or irreversible or bad decisions can be made based on the FR

RELEVANCE is more important: timing is crucial, risk of bad information can be mitigated by clever stakeholders

Question 6

Relevance

Answer 6

QUALITATIVE

Relevant: Timing is important. FR should give info that is needed at the moment. Can affect decisions

Question 7

Reliability

Answer 7

QUALITATIVE

Accuracy is the most important factor. Information must all be correct

Question 8

Percentage of completion method

Answer 8

Costs incurred to date / total costs of contract

If not, use discounted cash flow

Question 9

IAS 16

Answer 9

Firms can still pick HCA or FVA

Against IFRS goal of promoting consistency and comparability

Question 10

IAS 11

Answer 10

Long term contracts follow %of completion

Question 11

Prudence

Answer 11

Conservative and cautious judgement in accounting

For example, accounting for depreciation but not for asset appreciation (HCA method). Other examples are BDP or impairment testing

IFRS (FVA) places less emphasis on this

Question 12

Consistency

Answer 12

Reporting must maintain the same method of accounting across different time periods to maintain comparability

If consistency cannot be maintained, the reporting entity must disclose the change, the reason for the change, as well as impact of the change.

Question 13

Materiality

Answer 13

Information that has the ability to affect the decisions of the users is “material”

Auditors decide whether information Is material and dictates where this information is shown (BS/IS or just footnotes)

Question 14

Matching

Answer 14

Match revenue to expenses

Question 15

Deferred tax assets

Answer 15

Are illiquid and unsafe assets

This is because they are only refunded out of future tax (requiring a profit) and also have an expiry date.

Question 16

Problems with HCA

Answer 16

Continuous depreciation leads to assets with tiny residual value, despite its market price being far higher. Leads to massive selling profits

BS does not reflect true value of assets. Little relevance to investors

Question 17

Problems with FVA

Answer 17

Annual revisions to market price is VERY costly

Illiquid markets lead to mark to model (unreliable and manipulative) or to HCA (inconsistent)

Pro-cyclical and leads to volatility. In a downturn, prices are depressed. Recent recession had billions of asset write-offs. Leads to lower profits and capital ratio issues

If the market value of a firms liabilities (such as bonds) falls, it can book this as a profit

Built on EMH, which has many problems

Enron had massive profits by following FVA and marking to market

Question 18

FVA vs HCA

Answer 18

FVA is performance, HCA is health
FVA is relevance, HCA is reliability

HCA is better due to the shortcomings of FVA (especially in distressed times). With markets being imperfect in reality, the market value does not always reflect the FAIR value

Question 19

Pros of Global Standardization

Answer 19

Increasing comparability and transparency leads to more efficient markets

Lower costs of preparing financial reports and easier cross-border business (no need to prepare one in each country)

Question 20

Cons of global accounting standardization

Answer 20

Comparability on the surface, but there are many assumptions that feed into accounting.

Removes Darwinian competition, there may be no progress in standards. How do we know ours is the best?

Different countries have different emphasis on the key objective of FR. US focuses on shareholders, UK focuses on accountability

Cultural and national interpretations of transactions will differ

Mainly benefits large firms owned and traded in multiple countries. Not much effect on SMEs

International standard setter is less accountable: reports to no one

Political standardization will be difficult

Question 21

Global accounting standards conclusion

Answer 21

A uniform classifications of transactions that occur in diverse environments is logically impossible

Standardization is too simplistic and thus is bad

Question 22

Stock options

Answer 22

Under IFRS, stock options are expenses (traditionally just a double entry when exercised)

Question 23

Stock option treatment

Answer 23

Traditionally there was no line entry when a SO was issued. When exercised: Debit Cash, Credit share equity.
Under IFRS, SO must be expensed when issued. Expense is difference between what firm could have received from selling shares in future and what it actually receives from the employee. Upon issue: Debit SO Expense, Credit SO

Question 24

Cons of expensing stock options

Answer 24

Options are valued by Black-Scholes. Requires 6 inputs, and assumes stable markets and works on estimates. Problematic, subjective, and complex model.

An SO is a promise: there has been no transaction. Should there be a line entry if there is no transaction?

Effect of SOs can already be seen through diluted earnings per share. This is calculated based on outstanding SOs and should be incorporated into valuations

Question 25

Pros of expensing stock options

Answer 25

Without expensing, profits of major companies may look very inflated.
AOL Time Warner 2001: if SOs were expensed, would have faced operating loss of 1.2 billion instead of the 700million income it reported.

Question 26

Stock options expensing verdict

Answer 26

Don’t expense
Black scholes is unreliable in an increasingly volatile stock market
Analysts can calculate SO expense through dilution

Question 27

Definition of Arbitrage

Answer 27

An opportunity to make a risk free profit without investing one’s own money.